High valuations are forcing firms in the US mid-market to look beyond the obvious for deals. Firms in the sector are focusing more on add-on acquisitions, which are cheaper, while the lower mid-market, which had softer valuations, has seen an increase in transaction volume.
“The market in 2016 continued to be very strong, perhaps overpriced, but with opportunities to find value if you looked hard enough,” says Bela Szigethy, co-chief executive of Riverside Company.
He noted that valuations for mid-market companies had an of 11x EBITDA in 2016, while valuations for add-ons were closer to 6x EBITDA. “Add-ons are required today to get the blended purchase multiples down,” he says, adding that bolt-ons also help contribute to the growth of an existing company. “It's such a predictable value-creation driver.”
Riverside had made 58 transactions by mid-November; 34 were add-ons.
Inflated valuations and a focus on smaller bolt-ons have inevitably hit transaction volume.
There were 1,330 mid-market transactions in the US in the first three quarters of 2016, totalling $265 billion, according to PitchBook. The deal value was down 9.7 percent year-on-year, while the number of deals fell 16 percent. The core and the upper mid-market were particularly badly hit.
“In terms of the dollar volume of deals, it looks like it's been a pretty decent year,” says Jeremy Swan, who leads the private equity and venture capital practice of consulting firm CohnReznick. “However, when you dig into the number of transactions, we're certainly well below where we were last year and well below a number of years past.”
Valuations have remained elevated despite subdued growth in the United States, because corporations have plenty of cash, private equity firms have lots of dry powder and debt continues to be relatively cheap, Swan explains. “Private equity firms are now having to pay higher premiums for deals that are not of the highest quality,” he says.
Some general partners have opted to dive into the lower mid-market to find more affordable companies to purchase.
Transaction volume in the sector stood at $28 billion at the end of the third quarter, almost surpassing the $30 billion-worth of transactions seen in all of 2015, according to PitchBook. But valuations are creeping up.
“We're seeing a tick up in valuations and you need to be very selective in the assets and investments you look at,” says Vincent Fandozzi, head of Ardian's North American direct investment business, which focuses on the lower mid-market.
“We've now had a good six months of solid equity market and financing market, and anytime you get a long period like that, clearly that creates more lender confidence and with that, the lending multiples continue to creep up and that impacts valuation multiples.”
Fandozzi, who notes that his firm finds value in more complex transactions with less competition, says the auto and building materials and products sectors experienced some softness. Sectors including services, particularly industrial services, basic materials and manufacturing, continue to be attractive.
“We're still feeling fairly good about what we're seeing,” Fandozzi says.
In the first three quarters of the year, private equity-backed exits in the US mid-market totalled $51 billion across 593 sales, decreasing 33 percent and 20 percent year-on-year respectively, according to PitchBook.
Most exits were sales to strategic or corporate buyers, which have been able to pay high multiples thanks to their large coffers, while the market for initial public offerings was mostly closed in 2016.
Fandozzi noted that firms in the sector are pre-marketing their portfolio companies to potential strategic buyers earlier than they used to. “Ultimately, when private equity is ready to sell, the strategics have already thought about whether it's a good asset for their business.”
But firms have been forced to focus more on operational improvement at portfolio companies to create growth and add value, which is helping maintain return expectations.
If inflation keeps its upward trend and the Federal Reserve starts increasing interest rates, valuations will start falling, which could ultimately bode well for activity to start picking up again in 2017.
“I believe we're at a high in valuations, next year there'll be more pressure down than up,” adds co-chief executive at Riverside, Stewart Kohl.